Chapter 16

Chapter 16Principles of

Corporate FinanceTenth Edition

Payout Policy

Slides by

Matthew Will

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

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Topics Covered

Facts About Payout How Firms Pay Dividends and Repurchase Stock How Do Companies Decide on Payouts? Information in Dividends and Stock Repurchases The Payout Controversy The Rightists Taxes and the Radical Left The Middle of the Roaders

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Payout Policies

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Dividend & Stock Repurchases

-800

-600

-400

-200

0

200

400

600

800

1000

120019

8019

8219

8419

8619

8819

9019

9219

9419

9619

9820

0020

0220

0420

0620

08

Dividends Repurchases Remaining earnings

$ B

illi

ons

U.S. Data 1980 - 2008

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Dividend Payments

Exxon Mobildeclares regular

quarterly dividendof $.42 per share.

Shares start totrade ex dividend.

Dividend will be paidto shareholders

registeredon this date.

Dividend checksare mailed

to shareholders.

April 15, 2009 May 11, 2009 May 13, 2009 June 10, 2009

Declaration Date

Ex-dividend Date

RecordDate

PaymentDate

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Types of Dividends

Cash Dividend Regular Cash Dividend Special Cash Dividend Stock Dividend Stock Repurchase (4 methods)

1. Buy shares on the market2. Tender Offer to Shareholders3. Dutch Auction4. Private Negotiation (Green Mail)

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Dividend Payments

Record Date - Person who owns stock on this date received the dividend.

Ex-Dividend Date - Date that determines whether a stockholder is entitled to a dividend payment; anyone holding stock before this date is entitled to a dividend.

Cash Dividend - Payment of cash by the firm to its shareholders.

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Dividend Payments

Stock Repurchase - Firm buys back stock from its shareholders.

Stock Dividend - Distribution of additional shares to a firm’s stockholders.

Stock Splits - Issue of additional shares to firm’s stockholders.

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The Payout Decision

Executives who agree or strongly agree (%)

Dividend Decision Survey (2004)

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The Payout Decision

1. Managers are reluctant to make dividend changes that may have to be reversed. They are particularly worried about having to rescind a dividend increase and, if necessary, would choose to raise new funds to maintain the payout.

2. To avoid the risk of a reduction in payout, managers smooth” dividends. Consequently, dividend changes follow shifts in long-run sustainable earnings. Transitory earnings changes are unlikely to affect dividend payouts.

3. Managers focus more on dividend changes than on absolute levels. Thus paying a $2.00 dividend is an important financial decision if last year’s dividend was $1.00, but no big deal if last year’s dividend was $2.00.

Lintner’s “Stylized Facts,” as updated by Brav, Graham, Harvey, Michaely (2004)

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Information in Payouts

Dividends and stock repurchase decisions contain information

The information contained in the decisions varies Asymmetric information may be conveyed Dividend increases could mean overpriced stock

or increased future profits The signal varies based on prior information about

the company

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Attitudes concerning dividend targets vary

Dividend Change1

1

EPS ratiotarget

dividendtarget DIV

1

1

EPS ratiotarget

dividendtarget DIV

01

01

DIV-EPS ratiotarget

changetarget DIV-DIV

01

01

DIV-EPS ratiotarget

changetarget DIV-DIV

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Dividend changes confirm the following

01

01

DIV-EPS ratiotarget rate adjustment

changetarget rate adjustmentDIV-DIV

01

01

DIV-EPS ratiotarget rate adjustment

changetarget rate adjustmentDIV-DIV

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Dividend Policy

-15

-10

-5

0

5

10

15

Div Rise

Div Cut

Source: Healy & Palepu (1988)

Ch

ange

EP

S/P

rice

at

t =

0 a

s %

Year

Impact of Dividend Changes on EPS

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Dividend Policy

Before Dividend

After Dividend

New stockholders

Each share worth this before …

Old stockholders

… and worth

this after

Tot

al v

alue

of

firm

Total number of shares

Total number of shares

Example of 1/3rd of worth paid as dividend and raising money via new shares

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Dividend Policy

Firm

Old stockholders

New stockholders New stockholders

Old stockholders

SharesCash

Cash

Cash Shares

Dividend financed by stock issue

No dividend, no stock issue

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Dividend Policy is Irrelevant

Since investors do not need dividends to convert shares to cash they will not pay higher prices for firms with higher dividend payouts. In other words, dividend policy will have no impact on the value of the firm.

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Dividend Policy is IrrelevantExample - Assume Rational Demiconductor has no extra cash, but declares a

$1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend.

Record Date

Cash 1,000

Asset Value 9,000

Total Value 10,000 +

New Proj NPV 2,000

# of Shares 1,000

price/share $12

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Example - Assume Rational Demiconductor has no extra cash, but declares a $1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend.

Record Date Pmt Date

Cash 1,000 0

Asset Value 9,000 9,000

Total Value 10,000 + 9,000

New Proj NPV 2,000 2,000

# of Shares 1,000 1,000

price/share $12 $11

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Dividend Policy is IrrelevantExample - Assume Rational Demiconductor has no extra cash, but declares a

$1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend.

Record Date Pmt Date Post Pmt

Cash 1,000 0 1,000 (91 sh @ $11)

Asset Value 9,000 9,000 9,000

Total Value 10,000 + 9,000 10,000

New Proj NPV 2,000 2,000 2,000

# of Shares 1,000 1,000 1,091

price/share $12 $11 $11

NEW SHARES ARE ISSUED

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Example - continued - Shareholder Value

Record

Stock 12,000

Cash 0

Total Value 12,000

Stock = 1,000 sh @ $12 = 12,000

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Record Pmt

Stock 12,000 11,000

Cash 0 1,000

Total Value 12,000 12,000

Stock = 1,000sh @ $11 = 11,000

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Record Pmt Post

Stock 12,000 11,000 12,000

Cash 0 1,000 0

Total Value 12,000 12,000 12,000

Stock = 1,091sh @ $115 = 12,000

Assume stockholders purchase the new issue with the cash dividend proceeds.

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Dividend Theories

Leftists (M&M) - Dividend does not effect value

Rightists - Dividends increase value

Middle of the roaders - Leftist theory with some reality thrown in.

Residual Dividend Policy

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Dividends Increase Value

Market Imperfections and Clientele Effect

There are natural clients for high-payout stocks, but it does not follow that any particular firm can benefit by increasing its dividends. The high dividend clientele already have plenty of high dividend stock to choose from.

These clients increase the price of the stock through their demand for a dividend paying stock.

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Dividends Increase Value

Dividends as Signals

Dividend increases send good news about cash flows and earnings. Dividend cuts send bad news.

Because a high dividend payout policy will be costly to firms that do not have the cash flow to support it, dividend increases signal a company’s good fortune and its manager’s confidence in future cash flows.

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Dividends Decrease Value

Tax ConsequencesCompanies can convert dividends into capital gains by shifting their dividend policies. If dividends are taxed more heavily than capital gains, taxpaying investors should welcome such a move and value the firm more favorably.

In such a tax environment, the total cash flow retained by the firm and/or held by shareholders will be higher than if dividends are paid.

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Taxes and Dividend Policy

Since capital gains are taxed at a lower rate than dividend income, companies should pay the lowest dividend possible.

Dividend policy should adjust to changes in the tax code.

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0.101000.10100(%)return of rateAfter tax

78.9)94.04()72.410(1050.2)50.120(taxes)-gain cap(div

incomeTax After Total94.072.4.202.5012.50.2020% @Gain Capon Tax

4.0010.40050% @ divon Tax

05.151005.12100(%)return of ratePretax

4.7212.50gain Capital

97.78100pricestock sToday'

112.50112.50payoffpretax Total

100Dividend

102.50112.50price syear'Next dividend)(high

B Firm

dividend) (no

A Firm

97.789.78

10010

97.7814.72

10012.5

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Cash Flow

Operating Income 100.00Corporate tax at 35% 35.00After Tax income (paid as div) 65.00Income tax paid by investors at 15.0% 9.75Cash to Shareholder 55.25

In U.S., shareholders are taxed twice (figures in dollars)

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Rate of Income tax

15% 30% 47%Operating Income 100 100 100Corporate tax (Tc=.30) 30 30 30After Tax income 70 70 70

Grossed up Dividend 100 100 100Income tax 15 30 47Tax credit for Corp Pmt -30 -30 -30Tax due from shareholder -15 0 17Cash to Shareholder 85 70 53

Under imputed tax systems, such as that in Australia, Shareholders receive a tax credit for the corporate tax the firm pays (figures in Australian dollars)

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Dividend Theories

MRI = IRR

COC12 %

r

QTY $$$

Residual Dividend Policy

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Web Resources

Click to access web sitesClick to access web sites

Internet connection requiredInternet connection required

www.earnings.com

www.ex-dividend.com

www.dripcentral.com

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Chapter 16